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Contracts, Markets, and Prices: Organizing the Production
and Use of Agricultural Commodities
James MacDonald, Janet Perry, Mary Ahearn, David Banker,
William Chambers, Carolyn Dimitri, Nigel Key, Kenneth Nelson,
and Leland Southard
Agricultural Economic Report No. (AER-837), November
2004
Production and marketing contracts cover a growing share of
U.S. agricultural production. These formal written contracts
are increasingly used in place of spot markets, where commodities
are bought and sold for immediate delivery, to set prices for
agricultural commodities and market them, as well as to govern
product quality, quantity, and production techniques. The expansion
of contracting is closely tied to other developments in agriculture,
such as increasing farm size, greater demand for customized
products, and tighter product monitoring from production through
marketing.
What is the issue?
Contracts can provide farmers with important benefits, such
as reduced income risks, easier access to credit, or higher
prices for products with special attributes. For buyers, contracts
can deliver products with desired qualities that reduce processing
costs or fulfill consumer demands. But the use of agricultural
contracts may also carry costs. They limit farmers' decisionmaking
freedom, and they may lead farmers to exchange price risks in
the market for unexpected contract risks. By reducing spot market
volumes, contracts can increase the risks of trading in spot
markets, raising costs and undermining the value of traditional
USDA price reports (which are useful only to the extent that
they provide information about products moving through the whole
system). Finally, some observers argue that contracts allow
buyers of agricultural commodities to exploit market power and
reduce prices paid to farmers.
This report assesses what we know about agricultural contracting
in the United States. It synthesizes existing analyses to evaluate
contracting's effects on risk, productivity, market power, and
price discovery.
What did the study find?
• Contracts governed 36 percent of the total value of
U.S. agricultural production in 2001, up from 28 percent in
1991 and 12 percent in 1969.
• Spot markets still dominate the sales of major grain
and oilseed crops like corn, wheat, and soybeans.
• Contracts dominate poultry, hog, sugar beet, and tobacco
markets and cover from a third to a half of fruit, vegetable,
cotton, and rice production.
• Contracts are more likely to be used by larger producers
and for products with special attributes, such as corn or soybeans
with high oil content or animals raised on organic feed.
• While overall data for agriculture show steady expansion
in the use of contracts, dramatic shifts can occur quite quickly
for specific commodities. Tobacco and hogs each turned to widespread
use of contracts in just a few years, and producers expect a
sharp expansion of contracting in fed cattle.
• A major benefit of contracts is that they often offer
higher prices than farmers could receive in spot markets. Although
contracts can be designed to greatly reduce growers' risks from
price fluctuations, the study finds that producers may contract
mainly to secure higher prices for delivering products with
desired (and often higher cost) attributes. Well-designed contracts
also often lead to increased productivity, either by cutting
production or processing costs or by enhancing product value,
with only secondary attention to risks.
• Contract terms may, under some market conditions, allow
buyers to impose lower prices on producers. The exercise of
market power is of real concern in contract markets, which are
often concentrated markets with few buyers. But because contracts
can enhance productivity and response to consumer demand, broad
actions to ban or limit their use may raise production costs
and reduce demand for farm products. Thus, it is important to
identify contract terms that extend market power without reducing
efficiency.
• Contracting may complicate market price reporting. The
growth of contracting has affected USDA's voluntary price reporting
program for livestock, resulting in a drop in the number of
transactions whose prices are reported. This report looks at
the early effects of the government's imposition of mandatory
reporting of livestock prices in contract and spot transactions.
After overcoming some early transition challenges, USDA mandatory
livestock price reports now cover a much larger volume of transactions
than the voluntary reports were capturing. Deeper and more accurate
livestock price reports have yet to reverse the shift to more
widespread contract use, however, because contracts may continue
to more reliably tie prices to product attributes.
• Contracting creates an ongoing challenge for government
policy. To meet their own food safety, product attribute, and
environmental goals throughout their supply chains, processors
and retailers can use agricultural contracts to control many
farm-level production processes. The expanded use of contracts
raises several issues for government regulatory agencies with
responsibility for ensuring food safety, food attributes, and
environmental control. For example, should contractors bear
financial liability for food safety or environmental failures
at contractee farms? When should a contract be taken as evidence
of compliance with public regulations, allowing regulatory agencies
to shift inspection resources to facilities or activities that
pose higher risks to health and the environment?
How was the study conducted?
The report relies extensively on data collected through USDA's
annual Agricultural Resource Management Survey (ARMS), as well
as on predecessor surveys, to provide a comprehensive picture
of how contracts are used. The report then synthesizes existing
analyses of agricultural contracting to evaluate its effects
on risk, productivity, market power, and price discovery. This
synthesis makes it possible to arrive at conclusions that no
single or small set of studies can support. It also suggests
areas where further research would be valuable.
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